Is it not prudent of me to count my emergency funds as my bond/riskless allocation? How about if I am owed substantial amount of money that I have yet to receive?

To me these allocations provide the same safety net & Yield as Treasuries. So personally when I say I am 100/0, I am really 95/5 if you include the safety net, and 85/15 if you include accounts receivable.

Let me know how you would account for this in a practically speaking?

Keep in mind that I've only been investing for a few months, and that my advice to you might be worth only what you're paying for it. That said, here's my take:

Your emergency fund should not be counted as part of your asset allocation, because:
1) If stocks decrease in value, you'll have to either dip into your emergency fund to "rebalance", or let your allocation fluctuate freely (in which case there's no sense constructing an asset allocation at all!).
2) Conversely, if (God forbid) you ever need to use your emergency fund for an emergency, your asset allocation will be altered, and you'll have to decrease your stock position anyway, or (once again) just "let it ride" and defeat the purpose of having an AA.

You also shouldn't factor accounts receivable into your allocation for the same reason individuals shouldn't factor inheritance money from relatives into theirs:
1) You might not know exactly when (or if) you're going to receive it;
2) You might not be able to anticipate exactly how much its value will be.
3) Even if you can accurately plan for both of the above, you can still set your target AA now with currently available funds, and then split additional money received into the same proportions when investing it.

It also must be emphasized that there is no risk-free investment--not after accounting for inflation and taxes, anyway.

pauliec84, I tend to agree with you. I just don't buy the idea that you can time the market deliberately to lose, and that naïve investors can do this consistently.

My feeling is that what naïve investors do is more subtle. Their attempts to time don't win or lose on the average, but they greatly increase risk without increasing return. "Manager risk" in fact. They make good and bad bets randomly, and the random effects of their betting activity pile up extra fluctuations for the same return.

But then on top of this you have some kind of gambler's-ruin-like endpoint phenomenon. In this case, not ruin, but the panic sale. Again, that can't change the average, but it can reshape the distribution of outcomes. The interesting thing is that given that you've already decided to up your risk level and increase your dispersion of returns by trying to time the market, panic-selling during 2008-2009 is actually a rational move. It's a kind of hedging, in fact. A very big stop-loss order. And it is protective.

So what happens overall is that by trying to time the market you widen the curve, and by "deciding" to panic-sell at some "get me out" point you skew it. So you get what you always get. You are trading a lot of small losses for a few big wins. It doesn't look that way because the losses are not small, but they are always smaller than they would have been without the strategy (because few are so gifted as to panic-sell at the exact bottom). My work colleague, of mine, for example, sold out his all-stocks 401(k) portfolio in October of 2008, well above the very bottom.

Why would people do it? It is in fact shaping the distribution curve in a lottery-like manner. By trying to time the market they get the potential for bigger gains if they are right.

So let's say this behavior creates an distribution of outcomes with not-so-rare big losses and much rarer humongous wins. Where do the humongous wins occur? I think the answer must be, "in 2000." That is, there were probably any number of naïve investors who were lucky. They would have experienced great returns just by picking a moderate asset allocation and staying the course. But by piling in during the 1990s and luckily (because I don't believe it was skill) bailing in 2000, they experienced glorious, stratospheric returns. Such an investor would have done so well as to motivate others to emulate him.

The familiar slogan that can be used to justify this behavior is "cut your losses and let your profits run."

Here's the big point. Even assuming the naïve investors lack any ability to predict the future and pessimize outcomes, an external observer will see the not-so-rare big losses of the naïve panicky market timer, miss the even rarer humongous wins that counterbalance them, and say "those idiots consistently choose wrong."

I'm not too sure about any of this. But here's one of those garbage hand-waving sketches to show the concept, the not-very-baked idea. The blue line is the virtuous Boglehead stay-the-courser. The red and green lines are people who prefer to try to time the market because there is an upside to be had whether by skill or by luck--in reality it's luck but they think it's skill, but as with the lottery if you don't play you don't win and there are, visibly, people winning. The red line is the naïve investor who panic-sells as a stop-loss edge, and thereby has more frequent losses. The green line is someone with the courage of his convictions who fails less often because he rides the curve below the panicky guy's "get me out point" and often comes back, but fails more spectacularly when he does fail.

If true, it would mean that naïve investors are usually wrong, but you don't win with a contrarian strategy. You just get the other side of the deal. They get not-so-rare big losses and much rarer humongous wins. You get not-so-rare big wins and much rarer humongous losses.

nisiprius, great analysis. I think regardless of the negative market timer effect, the distribution altering effect you illustrated is correct.

Furthermore the resulting distribution could lead to the results presented in the two papers, as without enough "winning tickets," the observed returns could be downward biased. (note I have not read them in enough detail to know if they address this possibility, "dumb money" was peer reviewed so it may have).

One other possible factor in play may be the following. The following logic train.
1) Aggregate risk aversion is time-varying.
2) When the economy does well, aggregate risk aversion falls.
3) When risk aversion falls, people are willing to hold more stocks, ie "market timers" increase stock allocation.
4) When risk aversion falls, the risk premium falls.
5) Observed returns following capital inflows by retail investors is lower due to lower risk premium.

I think in this framework, efficient market holds, and we would see the market-timer have lower returns, but only because the capital inflows and risk premium are driven by the same underlying factor which is reduced aggregate risk aversion.

FWIW, I am a young investor, and I am very happy to be 30/70 even in a bull market. I will not feel comfortable having a larger allocation to equities until I have more money. The marginal utility of each additional dollar decreases as total dollars increase. Therefore the less I have, the less I can afford to risk. Right now, savings % has a far bigger impact on my account balance than return %.

raddle wrote:FWIW, I am a young investor, and I am very happy to be 30/70 even in a bull market. I will not feel comfortable having a larger allocation to equities until I have more money. The marginal utility of each additional dollar decreases as total dollars increase. Therefore the less I have, the less I can afford to risk. Right now, savings % has a far bigger impact on my account balance than return %.

Move to the head of the class! It could be argued that you are severely underweight stocks, but when just starting at say age 22, it isn't good to lose half the assets you've struggled to save five or six years later. Reasonable risk is the key.

Paul

When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

radionightster wrote:Now if you bought 100% stocks the last 10 yrs. right before retiring when you need the money then it is your fault. The worst the market has done in any 10 yr. rolling period since 1926 is -1.4%. The "lost decade" fits into that range and thus is the fault of the investor for being over aggressive a decade before retiring.

I think in the "lost decade" my portfolio did fairly well. I think the S&P500 did poorly in the "lost decade". I would like to see quantitatively what diffferent classes did in the "lost decade". Small cap, Mid cap did better.

The MPT curves show higher return with equal risk when using a small allocation to bonds. I am 64, recently retired and I recently allocated 15% to bonds. Before that I allocated 100% to equity. Bonds are extremely boring. Historically bonds return about 1/2 as much as equity. That is due to "risk premium".

I see the same handfull of lucid posters discussing their thoughts on risk management in individual portfolios, and promoting a balanced approach. This balanced approach had been promoted for years by an investing genius that was probably the most succesfull investor during a period where US stocks lost most of their value. A balanced approach gives you options and dry powder as compared to swinging for the fences with an all stock portfolio ignoring VALUATION and basing all decisions on back tested results.

The mind can create many fallacies when it comes to money management and Benifit/Loss understanding.

Back to Valuation.....Valuation does matter dosn't it? Do people consider this at all when they mention 100% stock portfolios? The past 10 plus years should have demonstrated that it is posible to over pay for an investment (house, stock, etc) to the point that you will never earn a return or break even during an investors time frame.

Last edited by nbatt on Wed Mar 09, 2011 5:29 pm, edited 1 time in total.

I think that this comment is relevant and it relates back to something nisiprius said on the first page.

As a fairly young investor (<30 years old), I find it intriguing that people actually thought that "this could be the big one" and that society might collapse during the whole financial mess. I try not to pay much attention to most financial news and perhaps remain quite insulated, but the thought never crossed my mind. I was too busy with my head down trying to raise private equity for a tech startup in 2008/2009 to even think that it was not just life as usual. Perhaps it is more shocking to someone who's entire investing career does not span only 1999-2011 (obviously accumulation is my biggest contributor at this point). All things considered I feel my fairly modest portfolio has done quite well over this period and I hope for sunshine and rainbows in the future. If nothing else perhaps the ups and downs of the past decade make an excellent introduction to the market and certainly provided lots of opportunities to get to know your true self.

Edit: To make sure it is on-topic, I am not 100% equities but am above 100-age.

As William Bernstein has said investors are not absolved from making rational estimates of future returns of various asset classes.

With wise people like Bogel, Malkiel, and Bernstein all seeing real equity returns in the single digits for the next decade I agree with Bernstein when he says in the Investor's Manifesto that it makes less sense to 100% in stocks at this time. Since writing this stock valuations have climbed further which of course drives down long term future returns.

I personally am not willing to accept more risk and be 100% in stocks for what is likely a lower equity premium.

The OP rational for 100% equity was in part on historical returns of asset classes. I believe that it is precisely this view that stocks will always outperform bonds (which seems dominant in the media & financial services industry) that has increased the risk that they won't always; because this view has driven up prices of those same stocks.

FWIW I am 35 and hold 30% bonds. During the crash in 2008 and 2009 I was only 15% bonds. I didn't sell and bought stock with my new contributions, but did not feel I had enough of a bond cushion to re-balance aggressively. My increased bond allocation has come primarily from new contributions in the last six months and is based on my IPS which I was sorely lacking in 2008.

raddle wrote:FWIW, I am a young investor, and I am very happy to be 30/70 even in a bull market. I will not feel comfortable having a larger allocation to equities until I have more money. The marginal utility of each additional dollar decreases as total dollars increase. Therefore the less I have, the less I can afford to risk. Right now, savings % has a far bigger impact on my account balance than return %.

Move to the head of the class! It could be argued that you are severely underweight stocks, but when just starting at say age 22, it isn't good to lose half the assets you've struggled to save five or six years later. Reasonable risk is the key.

Paul

**emphasis mine**

Paul, I understand what you are saying, but wouldn't it be more appropriate to add that only when an investor sells shares does he or she realize said losses? I don't mind losing half of my current value as long as I don't lose the shares. As a young accumulator buys shares at a cheaper and cheaper price, his future returns are higher and higher. Where I'm at in my investing life, I would love to see a 10 year bear market so I can buy equities at low prices, thus increasing my future possible returns.

It has been told to me that in my beginning years as an investor, rate of savings is much more important than rate of return. I am finally realizing that. As such, I'm not worried as much about my exact AA. However I still believe in my asset class choices that I am going to implement in five or six years.

**disclosure: I'm not 100% in equities, not even close. As someone else said, "All About Asset Allocation" clarifies it perfectly! One of my favorite intermediate level investing books.

raddle wrote:FWIW, I am a young investor, and I am very happy to be 30/70 even in a bull market. I will not feel comfortable having a larger allocation to equities until I have more money. The marginal utility of each additional dollar decreases as total dollars increase. Therefore the less I have, the less I can afford to risk. Right now, savings % has a far bigger impact on my account balance than return %.

Move to the head of the class! It could be argued that you are severely underweight stocks, but when just starting at say age 22, it isn't good to lose half the assets you've struggled to save five or six years later. Reasonable risk is the key.

Paul

**emphasis mine**

Paul, I understand what you are saying, but wouldn't it be more appropriate to add that only when an investor sells shares does he or she realize said losses? I don't mind losing half of my current value as long as I don't lose the shares. As a young accumulator buys shares at a cheaper and cheaper price, his future returns are higher and higher. Where I'm at in my investing life, I would love to see a 10 year bear market so I can buy equities at low prices, thus increasing my future possible returns.

It has been told to me that in my beginning years as an investor, rate of savings is much more important than rate of return. I am finally realizing that. As such, I'm not worried as much about my exact AA. However I still believe in my asset class choices that I am going to implement in five or six years.

**disclosure: I'm not 100% in equities, not even close. As someone else said, "All About Asset Allocation" clarifies it perfectly! One of my favorite intermediate level investing books.

Medic, the idea that you have to sell shares to actually realize a loss is false. What if you needed the money for something unplanned? It isn't going to be there. It isn't the things that we can imagine that do the most damage, it's the things we can't imagine. My reply was to raddle, not because of his very low allocation to stocks, but for his thinking, which does have merit. Where do investors get the idea that the stock market is going to always come out favorably? That the more you invest, the richer you will become? It does NOT always come out that way. It may in the long run, but the long run is only a series of shorter terms, some which may last half of a persons investing lifetime.

Rick J also provided some accurate perspective.

We generally use the ol' rule of thumb that investment losses are going to be about half of what our allocation to stocks is, but the cold hard fact is you can lose a lot more than that. We've already seen a crash which lost 90%. Can't happen again? A 50% loss requires a 100% gain to get even again, an 80% loss requires a 400% gain. The NASDAQ lost 80% in 2000-2002. A 90% loss requires a 900% gain. People do get wiped out. Why would anyone want to expose all of their saved money to this kind of potential risk?????

It's usually new, young investors who want 100% stocks, but young investors typically experience major changes in their life, so having money they can fall back on seems smart. And because of new commitments demanding new money, losing half of what may have been hard to save just isn't prudent.

In addition to what I've just written, read the following link, and then, if you thoroughly understand the risks, both short and long term, then go ahead and invest 100% of your money.

EDIT: One last point. Some investors, well aware of the nature of risk, can tolerate a substantial loss, but it's clear that many still bail when the market is down 50%. Why? Because once they are down 50%, they fear a deeper loss, which they cannot tolerate. That is the real threat. So, what happens to the investor who can grit his teeth and hold and the market does drop below a 50% loss. AT 60%, gains needed to recover begin to increase exponentially. 150% gain is needed go recover a 60% loss. So, it may not really be a question of whether the market can break you or not; the question may be how much is it going to take for the market to break you.

I think nearly every permutation of all possible opinions are well represented on this thread.

My own view is to start heavy in stocks, and stay that way into retirement. The greater average yield from stocks compensates for the lower risk of a blended portfolio. And re-balancing adds almost no risk reduction when measured over 25 years.

I believe that the "Age in bonds" rule is a good starting point BUT not the final answer. A person's risk tolerance always needs to be factored in.

example: Myself. I am in my early 30s saving for retirement. I got 2.5% of my retirement accounts in commodities and the remainder in stocks. I have 30+ years to go before I retire AND I am adding new money to the accounts every 2 weeks. In cases like mine, I don't think 100% in stocks is TOO Risky provided that they are diversified properly among the sub-classes (U.S. and international, growth and value, large cap and small cap).

However, if someone invests a lump sum as a result of a windfall (say an inheritance or a lotto jackpot win) with a 30+ year time horizon AND no plan to add any new money to the account in the future, then I believe 100% stocks is TOO risky AND bonds should be added to the mix. 30-50% in government and high-grade bonds would be good (depending on an individual's risk tolerance) with the remainder in equities, commodities, real estate, and high-yield bonds.

but forget that 40 years of stock market investing will generate a 500% increase- plenty of room to absorb a 30% loss.

How about an almost 60% loss (2007-2009). Or a 90% loss? Think an average person will absorb those losses with ease and not panic during retirement when the SWR appears have shifted? Perhaps you may hand in there (but can't tell cause you are not there yet or the event may not happen in that timeframe relative to YOU), but investor behavior says many won't if that happens to them.

IMHO Need of risk, your analysis ignores those black swan events that happen far more often than statistics say they should. It also ignores investor behavior, that's why certain people should utilize investment advisors. But there are enough quality ethical advisors out there who charge much more reasonable fees than you mention in the article - which I believe you should mention.

As per your article, heavy in stocks appears to be 80%. Even at that level, if someone had $2MM portfolio at last peak and it dwindled down to around $1.1MM (taking into account dividends and bond interest), I would expect to see some investment behavioral changes for the majority.

BornInCA wrote:
However, if someone invests a lump sum as a result of a windfall (say an inheritance or a lotto jackpot win) with a 30+ year time horizon AND no plan to add any new money to the account in the future, then I believe 100% stocks is TOO risky AND bonds should be added to the mix.

Actually, I've done the analysis in this particular case. Assuming the stock market remains volatile but returns more than bonds, it makes sense to keep ALL your funds in stock in the case of a windfall. That's because it offers the longest time to allow the average to dominate the return. On the other hand, if you invest yearly, some of your new money will enter in a falling market, and you may die before the average return is achieved on that NEW money. Most analysts believe it takes 25 years for the average to occur- a long horizon to be sure...

Absolutely correct. This "percentage ratchet" effect is a myth. What really happens on Wall Street is a tsunami hits, and some analyst calculates how many dollars of income will be lost in a company's business, and then reduces the stock target to match the new, lower enterprise value. When their Japanese subsidiary recovers, the add back in the same dollar amount. They do not drop the price by x%, and then raise it by x% on recovery.

(1) This is one of the best, most interesting, most intriguing threads ever.

(2) It takes a thread this long to cover the subject of risk accurately. I don't see how to make the discussion more concise, but it would be nice if we could

(3) Apropos probability of risk versus magnitude of risk. As a macabre illustration of this point, I read somewhere that the risk of dying in an airplane crash is approximately equal to the risk of dying from an asteroid crash that kills everyone. The latter is far less likely, but is far worse.

(4) Somewhat contrary to point #2 above. We all agree there is a nonzero probability that equities in aggregate will lose 90% of their value over the next 20 years. But is that something an investor should be worrying about, or is that something Bernanke should be worrying about? My point is that the worst of the worst downside risks are systemic in nature. In our society, systemic risks are dealt with collectively. Some Wall Street firms played this point masterfully in the last downturn. So an argument can be made that individual investors should not consider the blackest of the black swan events. On the other hand, what you think society should consider a systemic risk - i.e., "too big to fail" - might not be what society considers a systemic risk (e.g. surely some at Lehman Brothers expected to be treated as well as AIG).

(5)

nisiprius wrote:If anyone seriously believed that stocks when held for forty years were certain to outperform bonds, then some smart cookie would be offering stock-based bonds. Let's say the historical return of the stock market is 10%. I'd offer you a zero-coupon 40-year 9% bonds, invest the premiums in stocks, wait forty years, harvest the 10% gains, pay you 9%, and pocket my profit. Nobody does this, ergo nobody really believes it.

Isn't this what a Guaranteed Investment Contract is? One problem, among others, is they pay perhaps 2-3% below long term expected returns, not 1%.

gebgeb wrote:
Actually, I've done the analysis in this particular case. Assuming the stock market remains volatile but returns more than bonds, it makes sense to keep ALL your funds in stock in the case of a windfall. That's because it offers the longest time to allow the average to dominate the return. On the other hand, if you invest yearly, some of your new money will enter in a falling market, and you may die before the average return is achieved on that NEW money. Most analysts believe it takes 25 years for the average to occur- a long horizon to be sure...

Academically and theoretically, that may be right depending on the diversity of stocks. However, when I made the windfall statement, I took 2 things into account:

1.) investor behavior & psychology. If stock markets have a major correction, it's very challenging emotionally to stay the course. Suppose someone invests a lump sum in a broadly diversified stock portfolio thinking it won't be touched for 30 years. Then years later, the market has a major correction. If this investor bails out the market at that time, he or she has done harm and failed. If there is some high quality bond allocation, then it can be perceived as a relatively safe harbor by the investor. If the stock market skyrockets, he or she can lock in the gains by moving some of the stock money to safe harbor. If the stock market drops like a rock, he or she can take some "safe harbor" money and buy stocks at a discount. This is what rebalancing is all about. Assuming the investor understands this concept and applies it correctly at the right times, he or she would feel better and is more likely to "stay the course". The 30-year result of maintaining this balanced portfolio may underperform the 30-year result of the 100% stock portfolio BUT he/she would feel better emotionally. Even if there is a strong-willed, strong-minded, thick-skin investor who would be willing to stick with a 100% stock portfolio for 30+ years, there is another problem in #2.

2.) Who can say for sure he/she won't need any part of the windfall for another 30 years, especially if it's in a regular taxable account? That assumption is hard to implement. There is more to life than money. A lot of things can happen in 30 years. It's nearly impossible to believe that this person would never need or want to use at least some part of the windfall between the time a windfall is invested and 30 years after it has been invested. Even if this person would not depend on any part of a windfall to support his/her lifestyle, life happens. Examples are major medical expenses (need), paying for his/her college (need) or a loved one's college (need/want), home improvement/repair (need/want), or bailing someone out of jail (need/want). If and when any major life event happens, he/she may have to sell investments when they are their lows.

So academically/theoretically, it may make sense but is way too difficult to implement in real life.

BornInCA wrote:
However, when I made the windfall statement, I took 2 things into account:

1.) investor behavior & psychology.
2.) Who can say for sure he/she won't need any part of the windfall for another 30 years, especially if it's in a regular taxable account?

So academically/theoretically, it may make sense but is way too difficult to implement in real life.

Yes, if people behave against their long-term interests to feed their fears, then some bond allocation might reduce worst case behavior. And you might have to tap the asset during those 30 years, though of course after 15 years the higher stock yield generated enough extra cash to leave you ahead of a bond-only fund, even after a stiff market decline.

In between is in-between.

When I discuss investing with our extended family, about half understand the issues, and half prefer to shift responsibility to their broker. Of the half who understand the issues, only about half avoid panic during downturns and follow sound investing practices. The others fall behind the market.

Really not too surprising- despite ALL the accumulated evidence that a Bogle style investing program generates the highest, most reliable returns, I doubt a quarter of the market follows this program.

John Galt wrote:Thanks for all the replies, there are definitely some very smart people on this forum.

I plan on using the 120-age=% bonds formula. Since I'm turning 21 soon and there's no point in being 1% bonds, I will be 100% equities until I turn 25 at which point I will DCA into 5% bonds.

p.s. I was 100% equities throughout the 2007-09 crisis

Sounds like a desired return outcome is driving the risk decision. This is your first lesson in investing. Go to the mirror and convince yourself you aren't just rationalizing a desired outcome (i.e. lying to yourself out of greed).